The Tools of Corporate FinancePresent ValueFinancial Sta.ppt

The Tools of Corporate FinancePresent ValueFinancial Statement AnalysisFundamentals of Valuation Present Value Aswath Damodaran Intuition Behind Present Value There are three reasons why a dollar tomorrow is worth less than a dollar today Individuals prefer present consumption to future consumption. To induce people to give up present consumption you have to offer them more in the future. When there is monetary inflation, the value of currency decreases over time. The greater the inflation, the greater the difference in value between a dollar today and a dollar tomorrow. If there is any uncertainty (risk) associated with the cash flow in the future, the less that cash flow will be valued. Other things remaining equal, the value of cash flows in future time periods will decrease as the preference for current consumption increases. expected inflation increases. the uncertainty in the cash flow increases. Discounting and Compounding The mechanism for factoring in these elements is the discount rate. Discount Rate: The discount rate is a rate at which present and future cash flows are traded off. It incorporates - (1) Preference for current consumption (Greater ....Higher Discount Rate) (2) expected inflation (Higher inflation .... Higher Discount Rate) (3) the uncertainty in the future cash flows (Higher Risk....Higher Discount Rate) A higher discount rate will lead to a lower value for cash flows in the future. The discount rate is also an opportunity cost, since it captures the returns that an individual would have made on the next best opportunity. Discounting future cash flows converts them into cash flows in present value dollars. Just a discounting converts future cash flows into present cash flows, Compounding converts present cash flows into future cash flows. Present Value Principle 1 Cash flows at different points in time cannot be compared and aggregated. All cash flows have to be brought to the same point in time, before comparisons and aggregatio